Committee to review FRBM targets

I was on ET Now along with Prof M Govinda Rao to discuss this topic.

My view is that there is  a strong case for revisiting the targets. I give many reasons. Here I will mention two. One, our deviating from the FRBM target for nearly a decade past the deadline has not led to an unsustainable debt  situation. On the contrary, India is among the few economies whose debt to gdp ratio has declined over the past decade- at 67% of GDP today, it looks quite okay.

Two, we worry about the fiscal deficit because it can impact on interest rates. The impact on long-term rates of fiscal deficits is negligible, as empirical work has shown. However, the deficit can impact on short-term rates. On this count, concerns must be subdued at the moment given relatively low oil prices.

More fundamentally, I would question the idea that the way to reduce the fiscal deficit to GDP ratio is to attach the numerator, that is, reduce expenditure and, if possible, raise tax rates or increase the tax base. The point is that that is not how our ratio came down significantly in the first decade of the 2000s when we were almost close to attaining the 3% FRBM target at one point.

Rather, the numerator, the GDP, shot up due to exogenous factors, such as the global boom, and also due to the increase in the savings and investment rate over time. This also caused the numerator to decline because tax revenues rise with rising GDP.

The bottomline: the presumption that reducing the fiscal deficit is the key to better or stable growth must be questioned. It's very often the other way round. You do various things to boost growth - and the the fiscal deficit to gdp ratio takes care of itself. 

Rajan controversy generates more heat than light

A fair bit of dust has been kicked up by Subramaniam Swamy's letter to the PM asking that RBI Governor Raghuram Rajan not being given another term in office. However, it's disappointing that much of the analysis focuses on personalities and does not attempt an objective analysis of Rajan's performance. There are three areas in which Rajan needs to be judged: monetary policy, bank regulation and foreign exchange management.

Most of the controversy is over Rajan's handling of monetary policy. The charge against him is that he reduced interest rates too late and too little. But the reluctance to cut interest rates arises from the more fundamental policy of inflation targeting and the particular band - 4 to 6 per cent- to which the RBI has committed itself. This leaves little room for flexibility on interest rates and its inevitably corollary is a certain loss of output in the short-run. Since the finance ministry agreed to this policy, it would not be correct to fault Rajan alone for this policy. I believe there is room to revisit this policy.

On bank regulation, Rajan has moved to open up space for niche players such as payment banks and small banks while also promising on-tap licenses. Foreign banks have been noticeably reluctant to come in through the subsidiary route given the requirement of capital. The cumulative impact of these policies on the competitive situation  will not be significant in the medium term.

In respect of public sector banks, it is the finance ministry that has called the shots even on matters of governance. The overhauling of bank boards and the appointment of new CEOs for banks is yet to happen- and it will happen under the auspices of the Bank Board Bureau on which the RBI will be represented through a Deputy Governor. My own view is that having the RBI Governor head the appointments process would have been a better bet for now if only because the Governor (and I don't mean this particular governor) is more capable of exercising the necessary independence in this matter. Rajan must given due credit for not having bought the line on bank privatisation- I am surprised that his remarks on the need to improve governance in the private sector first have not got the attention these deserved. Rajan has also been circumspect on PSB consolidation- he has indicated that it may not be appropriate to burden PSBs with mergers at a time when they face several other challenges.

Finally, forex management. There is a school that believes that the RBI has helped shore up the rupee unduly and that this has hurt exports. This could be true but there are serious risks to rupee depreciation at a time when emerging markets have faced large outflows of capital. On balance, it appears that erring on a slight over-valuation was worthwhile.

We must also give Rajan due credit for upholding the stature and independence of RBI and for his efforts at communicating with audiences in India and abroad. For Rajan, it must be some consolation that he's not the only central banker under fire at the moment. In the UK, politicians have asked for Bank of England governor ( a Canadian by the way) to be sacked for saying that Brexit could have serious short-term implications for the British economy. ECB chief Mario Draghi has been bashed by the German finance minister for his unconventional monetary policies. And Janet Yellen, the Fed chief, would not have been pleased to hear that Donald Trump would replace her if re-elected.

Fresh storm over executive pay

Executive pay has been  a subject of controversy for several years but nothing has come out of it all- CEOs are still laughing they way to the bank.

Small wonder that a fresh storm has erupted over some of the most recent news on executive pay. British Petroleum boss was given a 20% rise in a loss making year for the company. Although this was rejected by shareholders, the vote was non-binding. And VW's recently departed CEO got 6 million pounds as performance-related award despite the scandal that has sent the company's stock plummeting.

In the UK, hedge fund TCI  has taken a stake in VW in order to shake up its governance, FT reports. 
The reason put forward by its head is an interesting one. It's not the cost of CEO pay itself; it is that aggressive incentives lead to bad behaviour that impose costs on shareholders. Think of what happened at the leading banks in the world in the financial crisis of 2007.

Norway's oil fund, the world's biggest sovereign fund, has decided to take a position on executive pay. By this it means, the level of pay, not just the structure of the pay package.

The moves by the two funds are a good start. CEOs can get away with outrageous pay packages thanks to boards packed with yes-men. Also because institutional investors are not willing to invest the time and effort required for reform of pay. One reason is that those at the head of institutional investors themselves command huge packages, so it's a case of  birds-of-a-feather. Who wants to invite attention to their own obscene packages?

A third reason for soaring CEO packages is that investors don't really mind as long as the going is good- they are certainly not concerned about things like equity that angers social activists.

The best argument to make is not a moral one. It is that outsized pack packages are not in shareholders' own interests. They will lead, one way or another, to under-performance in the long run  because performance is the result of collective effort, it's not magic wrought by one person. If you focus too much of the reward one person, the collective effort is undermined.

Don't expect bankruptcy code to change things overnight

The Bankruptcy Code, passed by the Lok Sabha and pending in the Rajya Sabha, is a considerable improvement on existing bankruptcy procedures:

• It brings disparate insolvency procedures under a uniform institutional structure 
• It sets a 180 day time limit for resolution
• It keeps insolvency matters out of the purview of civil courts
• It has provisions for Insolvency Professionals who will be part of the insolvency resolution and will be incentivised through fees linked to recovery

 There are three issues that the Code cannot and does not address:

• Legacy NPAs at banks- so it's not going to help address our immediate problems
• Bankers being unwilling to take a loss in restructuring cases, given the fear psychosis in banking. Given this, it's not clear how they can stick to the 180-day deadline
• Clogging up of matters in the adjudicating authorities and appellate tribunals to be created- the necessary infrastructure will take long to create and will not be equal to the sheer volume of cases, given our past record. Governance of regulatory and appellate authorities badly needs improvement- and not just in respect of bankruptcy.

More in my article in Quartz,why-indias-new-bankruptcy-code-wont-fix-its-broken-banks-overnight/

Default drama in banking

I was on Bloomberg TV yesterday to discuss issue related to loan defaults and how to address this issue.

Vijay Mallya's offer

Excuse me if I sound naive or I am missing important details but it seems to me that, on the face of it, businessman Vijay Mallya's offer to banks is a pretty decent one and banks should get into serious talks with him. They can hope to write back losses and boost profits in the quarter ahead if they do so.

FT reports today that Mr Mallya is willing to repay 440 million pounds out of a principal amount of 512 million pounds. The Indian papers had reported an offer of close to Rs 7000 crore. The banks need to clearly indicate what figure is acceptable to them and what terms they would like. Simply rejecting an offer does not take us anywhere.

Bankers know very well that going down the legal route- getting Mr Mallya extradited and, perhaps, arrested on return- will not take them very far. Indeed, the danger is that a legal battle will stretch out for years and the banks get back very little. The government needs to make up its mind: does it want to get Mr Mallya or does it want the banks' money back?

I had a chance to talk to some bankers. They all agreed that they go for Mr Mallya's offer. However, they told me they would not lift their little finger until the government told them in writing that that they could go ahead. As one of them put it," Who wants the CBI after him five years from now?".

It's a pretty sad state of affairs. We are faced with banking paralysis today, a variant of the policy paralysis that undermined the UPA government. Stalled projects can't go through to completion because banks are unwilling to take a hair-cut and plough in fresh funds. They can't effect recoveries again because they can't take the necessary hair-cuts. Because they can't effect recoveries, their capital position is worsening and they are unable to make new loans. Fear psychosis has gripped bankers in the public sector- so much so that bankers are now focused on retail lending and would like to stay out of corporate loans and especially project finance.

Banking paralysis is, perhaps, the biggest factor impending our economy recovery along with falling exports. The government needs to get its act together. The steps required are: an independent Settlement Advisory Board to vet loan settlements; recovery followed by fresh lending; and infusion of greater capital into banks. Without this combination of measures, prospects of accelerating growth are pretty dim.

Here is a quote from Mr Mallya's interview with FT:

Chain-smoking cigarillos and sipping English tea, the pony-tailed multimillionaire confirms he has offered, in a submission to India’s Supreme Court, to repay £440m on outstanding principal of £512m borrowed from state banks. 

But the banks declined because — in his words — they are fearful of taking any haircut on their loans in the face of the public frenzy whipped up against him in India.
“It is important to understand the environment in India today. The electronic media is playing a huge role not just in moulding public opinion but in inflaming the government to a very large extent.”

.....Mr Mallya blames the political climate for the failure to reach a deal with the banks, a climate that saw him described this week as a “fugitive from justice” by the country’s attorney-general.
“As professional bankers, they would like to settle and move on but, because of my image as portrayed, they are reluctant to be seen as giving me any discount,” he says. “It will attract huge media criticism and inquiries by vigilance agencies in India.”

World economy: welcome to the 'new mediocre'

World economic growth in 2016 will be poorer than thought earlier. Ditto in 2017- so says the IMF.

In terms of market values, world output will grow at 2.4 % in 2016-  growth of around 3% is considered modest. Is this a short-term thing or does it presage a long-term trend?

Many economists think it's the latter. The world is entering a period of low growth- what IMF Managing Director Christian Lagarde calls the 'new mediocre. Why is the world sliding into a low growth era. There are several competing hyptheses:

i Secular stagnation: This is a term coined by Alvin Hansen, an economist, in the 1930s. It has been resurrected of late by Larry Summers. The basic idea is that demand for goods is declining for a number of reasons. One is low population growth in the developed world.Another is that modern industry is less capital intensive and hence demand for investment goods is lower per unit of output than before- consider that   Facebook is worth billions in market cap while employing a fraction of what GM or GE employ. Thirdly, inequality is rising. This means the rich appropriate more and more of incremental income. They can consume only so much, so spending is impacted and so is investment. We have high savings and low investment, which is what explains why real interest rates are so low today.

ii. Liquidity trap: This is Krugman's view and it's a variant on the above. Monetary policy is ineffective at the low interest rates we have today and hence can't do much to stimulate output

iii. Falling productivity: Richard Gordon argues that economic growth is simply population growth multiplied by productivity growth. Both are falling. So, we have to accept that growth will be low in the years to come.

iv. Debt overhang: This is the view propounded by economists Rogoff and Reinhart. There's excess debt in the world economy following the financial crisis. Coming out of the debt overhang typically takes very long.

Now, if you accept any of the above, it means that it's futile for policies to push growth (although Summers think that public spending on infrastructure in the developed world can still make a difference).

The IMF in, its latest World Economic Outlook, seems to think that current growth rates represent policy failures- too much reliance on monetary policy and too little on fiscal policy and structural reforms. A combination of these along with moves to put life into banking systems in the Eurozone and elsewhere could make a difference.

I doubt that the political will exists for the purpose. I also believe that geo-political risks are pretty high, given the return of the  Cold War. So, we're going to be stuck with the 'new mediocre' for a while. That's bad news for those hoping for a return to 8 per cent plus growth rates in India.

More in my article in the Hindu, How to better the 'new mediocre'.

I have to say the title is rather deceptive- I argue there's little you can do to better the 'new mediocre'.

Indian banking prospects

I have a detailed paper in EPW on The changing face of Indian banking


My conclusions:

India’s banking sector is going through a period of stress. It is as if the global financial crisis is impacting the Indian economy and Indian banking with a lag. It would be unwise to draw conclusions or prescriptions about Indian banking by looking at performance indicators over the past three years of stress. One has to consider the post-reform period as a whole and, in particular, the decade of 2003-12. Over a long period, there has been a secular improvement in efficiency and stability. It is important to understand that public ownership has been an important factor underlying this trend.

While competition is set to increase in the coming years, it is unlikely to impact full-scope commercial banks in a significant way, except for PSBs that have lagged behind badly in technology and performance. There is scope for improvement in the performance of PSBs within the framework of public ownership. We need to strengthen management and governance at PSBs while recognising the uniqueness of the PSB model. The answer does not lie in getting PSBs to conform to practices of private banks.

It is important to find ways to deal with stressed assets in the system. This entails creation of an independent authority to vet restructuring agreements between PSBs management and promoters, infusion of greater capital into PSBs than is currently envisaged and resolution of various issues in the economy at large.

 

Water crisis and the IPL

Read an excellent interview with Yogendra Yadav on the furore over the water crisis in Maharashtra and elsewhere and the question of moving IPL out of the state (since ordered by the High Court).

It's not that IPL is going to impact the water situation. It's just it seems rather extravagant in the face of a crisis:

I am in favour of shifting the matches. Not because I feel there is any relation to the IPL matches and the drought, not because the IPL is aggravating the drought, nor do I believe that shifting IPL matches from these grounds will alleviate the drought.
There is no direct relation, but there's a symbolic relation. The IPL is not a sport, but an extravaganza. It is a festival.
It is a tamasha and there is something obscene and vulgar about holding this kind of festivity in the middle of a drought.
And how would not holding the IPL matches help? It would help not in terms of litres of water and so on; all these arguments are silly. This entire controversy, this judgment and the petition has served one cause -- it has reminded this country that there is a severe drought.
Over 50 crore (500 million) Indians are currently suffering from a livelihood crisis, something to which the whole country had shut its eyes for the past six months.
The drought began in October 2015. We conducted our first Samvedna Yatra on October 2 and the whole country was ignoring the situation. If this IPL controversy wakes the country up to this reality, I cannot complain.

Yadav says the solutions to the water problem are all there in government documents:

Some of the most effective and routine things they should have done, about which everyone knows, is to repair canals, hand pumps and water supply channels and identify affected areas. These are routine matters about which every bureaucrat knows.
All this has been written in a Government of India document, Manual for Drought Management. It spells out the steps that need to be taken to avoid this (water crisis).
But, politically, a more difficult thing which they needed to do was to disallow growing sugarcane in drought-stricken areas. Sugarcane is one of the most water-guzzling crops. We gave this suggestion also.
Second, opening of new sugarcane and liquor factories could have been postponed by six months. Our third suggestion was to regulate water bottling plants, which take away some of the best potable water.
Moreover, diverting water for industrial purposes can't be a priority at a time when you have such a serious water crisis. We had suggested regulating this.

Global growth: medium-term prospects are tepid

The world is not about to return to rapid growth in the medium-term. Recovery will be slow in both advanced and emerging economies. Because people don't see a rapid recovery in the future, demand will be depressed today. Those are the bleak messages from Olivier Blanchard, IMF's former Chief Economist.

Blanchard notes that estimates of long-term potential growth have come down by 0.5 to 1 per cent since 2007. The reasons? Ageing and low productivity growth. Blanchard writes:

Productivity growth has been much lower since 2007, more so in Europe where the rate has declined by over 1 per cent in major countries, than in the US, where it has only declined by 0.5 per cent. This decline reflects in part cyclical factors and the effect of lower capital accumulation. But there is more to it: for the US at least, the evidence points to a slowdown in underlying productivity, starting before the crisis and reflecting the end of a period of successful implementations of IT innovations. The safe assumption is that the high pre-crisis productivity growth rate was unusual, and we should expect lower underlying productivity growth in future.

Expectations of the future feed into the present. When people believe that things aren't going to be a lot brighter in future, they will cut back on spending, whether investment or consumption. That will affect the ongoing recovery in the advanced world. Lower growth in the advanced world will impact emerging markets through lower demand for exports and a drop in commodity prices. Add to this the slowdown in China because of problems internal to that country and the picture is complete.

Blanchard believes there's little that policy can do to change the picture- neither negative interest rates nor helicopter money can change the long-term reality.

If this is correct, we in India should be bidding goodbye to growth of over 8 per cent in the medium-term. For 2016-17, the upper end of the range forecast by the finance ministry, 7-7.75 per cent, should be a challenge.

Central banks' push into negative territory is not working

Central banks have tried one thing after another since the 2007 financial crisis: lower interest rates, quantitative easing and, most recently, negative interest rates. They aren't getting the results they want: the IMF has recently again downgraded its growth forecast for the world. So, what next?

Well, one thing to understand, as Martin Wolf points out, is that negative interest rates are not entirely the work of the monetary authorities. Central banks are merely responding to supply-demand conditions. Where investment demand is way below savings, rates are bound to fall- and they could go into negative territory as well. Wolf writes:

Some will object that the decline in real interest rates is solely the result of monetary policy, not real forces. This is wrong. Monetary policy does indeed determine short-term nominal rates and influences longer-term ones. But the objective of price stability means that policy is aimed at balancing aggregate demand with potential supply. The central banks have merely discovered that ultra-low rates are needed to achieve this objective.

Wolf is right. He is also right in pointing out the big danger that goes with negative rates. Banks are passing on negative rates to borrowers but not depositors for fear that the latter will not park funds with them. This is bound to impact banks' bottom lines and threaten financial stability. The other concern with negative rates is that they low rates are getting consumers to save more, spend less- a point made by Larry Fink of Black Rock.

So, what do we do? The Economist has urged more unconventional measures: monetisation of the government's deficit (or helicopter money) and pushing up wages through tax incentives. Both will cause an increase in inflation and hence in aggregate nominal demand.

The Economist correctly points out that there is a more conventional tool that governments can employ: fiscal policy. It is worth pushing up public debt when the cost of it is as low as it is today. The time is ripe for a massive push to infrastructure in the advanced economies (exactly what we are attempting here in India today under different conditions).

Finally, the advanced economies of Europe need to get their banks' balance sheets into shape (again, echoing conditions in India). This means writing down bad debts and raising capital from the markets. The problem for European banks is that markets may not be in a mood to advance them funds. We are better placed here given that 70 per cent of banking assets are with public sector banks and the government can infuse funds into them instead of having them raising money from the market.

Lower interest rates, fiscal expansion and bank balance sheet repair- the ingredients of a recovery are much the same in the advanced economies as in India although the relative weights for each may vary.

How do you attract and keep millenials?

That's the biggest challenge that firms face today: how do you attract bright, young people and how do you keep them?

Lucy Kellaway has a scathing piece in FT on what you should NOT do and what you might do.

The standard answer, which she got from a Columbia university prof, was: motivate through learning, market your benefit, invest in HR.When she put this to her kids, all beginning to work, it was met with derision.

What puts off new recruits to a firms and makes them want to leave sooner rather than later? One reason certainly is that they don't get the necessary respect or attention:

One graduate told me she had just spent four months working on a deck of 250 PowerPoint slides no one would ever read. Another said juniors at her law firm were expected to nip out to buy sandwiches for seniors, as if they were their fags at Eton. A graduate with a first in English from Oxford university said her boss insisted on checking every email she wrote before it was sent, making her doubt her own ability to write a sentence. Almost everyone complained of the sheer stupidity of the tasks they were given to do. 

Another is the gap between expectations and the reality. Employers promise youngsters the most exciting jobs in the world and then go on to under-deliver by a wide margin. Then, there is the gap between what companies profess and what they practise:

More dangerous still is the gap between the corporate bullshit and the business itself.  A young graduate at a management consultancy tells me that every day it is drummed into him by superiors that the firm always acts in the best interests of the client. But every week he watches the same people trying to flog further costly services that the client doesn’t need. 

Kellaway has a simple answer to the problem of retaining millennials: stop promising big things and just try to make the job a little interesting.

I can assure you that this is not a British thing. A few months ago, a student of mine here at IIMA told me that he was in touch with dozens of his seniors. Not one of them was enjoying his or her job. They were sticking to their jobs because it meant a certain status and money and because there weren't too many meaningful alternatives (unless you wanted to go into academics).

Maybe my sample is biased but, amongst middle and senior executives I have come across in the public sector, I see less complaint, a greater sense of fulfillment. In many cases (such as the Railways), a very deep sense of loyalty. Clearly, all the money the private sector is throwing at people doesn't seem to be creating loyalty or satisfaction.

Fending off a boss who wants you to flout rules

The Economist cites a recent survey that showed that 9% of employees faced pressure from their bosses to compromise on their ethical beliefs; 21% of employees who reported misconduct at work said they faced retaliation from their firms.

How to fend off a boss who wants you to do the crooked thing? One study shows that if you sport a religious symbol at work, bosses are less likely to ask you to do something is illegal or immoral. Maybe there's merit, then, in sporting a cross or having an image of a god at work or even wearing a tilak.

I nearly fell for this. Until I came to the end of the article. There's another study shows that those who make a show of righteousness are not likely to act more righteously:

In a further experiment, Ms Desai gave her participants the opportunity to behave ethically or unethically. Then, in what they believed was an unrelated study, they were given the option of appending a moral quotation to an e-mail to others in their group and/or to one sent just to themselves. Those who chose to signal their righteousness only to the outside world were more likely to have misbehaved in the first part of the experiment. 

There's the risk, therefore, that if you wear your religiosity on your sleeve, the boss will think there's a better chance of getting you to bend rules.

Moral of the story: do not expect academic studies to enlighten you in such matters. Trust your own instincts.

Constraints on the US Fed

There has been talk of the spillover effects of the actions of advanced country central banks, notably the US Fed, on other economies. This limits the freedom of action of those economies, especially emerging markets.

It is equally true, however, that conditions in the emerging markets impose constraints on the actions of advanced economies' central banks, as an article in the Economist points out:

IN THE weeks after December 17th, when the Federal Reserve raised its benchmark interest rate for the first time in nearly ten years, confident Fed officials told markets to expect four additional rate hikes in 2016. It has been obvious for a while that this guidance was wildly optimistic. Economists have been downgrading growth forecasts and markets have been retreating. At its meeting earlier this month the Fed acknowledged reality: it not only left rates unchanged, but also signalled in its projections that it expects to raise them by just two notches this year. This climbdown was not a surprise, but it does conceal a surprising admission: that American monetary policy is constrained, in part, by conditions in global financial markets.

The main reason is that in integrated financial markets, no economy can afford to be out of step with policies in the rest of the world nor can policy makers ignore conditions elsewhere. Policies cannot be framed only with respect to conditions in the domestic economy. Last December, it seemed natural for the Fed to hike the policy rate given that unemployment rate was down to 5% and inflation was edging up to the 2% mark. However, the Fed hike had immediate repercussions:

In late 2015 the expectation of a rate rise in America sent capital gushing into the country, pushing up the value of the dollar and tightening credit conditions elsewhere in the world. An expensive dollar makes American exports less competitive and places a drag on growth and inflation in the American economy. The effect on investors’ appetite for risk is more immediate.

Between the Fed’s December meeting and early February, American stocks dropped by 10%; share prices in Europe and Asia fell by more. The spread between corporate-bond yields and those on safe government debt rose sharply (see chart). Not until mid-February, as policymakers around the world sought to soothe markets with promises to support growth, did the panic dissipate. Since then, share prices have recovered and the dollar has fallen in value; with its decision on March 16th, the Fed confirmed investors’ suspicion that it would not continue on its planned tightening path.

It is interesting that in these conditions, the very definition of an inflation target is changing. When the US Fed talks of a 2% inflation rate as its target, it does not mean the inflation rate at a given point in time. It means the average inflation rate over a given period. So, if inflation was below 2% in recent years, it can afford to be above 2% in the coming years. This is what one calls ex-post justification- after the event, you find an argument to justify your position.

Why we need the public sector in banking

Most people make the case for public sector banks (PSBs) on grounds of meeting large social need- inclusion, priority sector, regional development, etc.

There is, however, a more solid case to be made for PSBs. This is that PSBs are a force for stability. Private banking systems are inherently unstable, as a recent book, which I have reviewed in EPW, makes clear. The author, Adair Turner, former head of UK's FSA, argues that private banks have every incentive to expand credit as much as possible. An excess of credit leads on to boom and the inevitable bust. Given the low levels of capital required by banks, an economic bust means a banking crisis.

There's really no way to avoid a banking crisis in today's private banking systems without restricting their ability to create credit. The extreme solution was proposed years back by the Chicago School which argued for 100% reserves in banking- all bank deposits should be invested only in safe securities and banks should exist primarily for the purpose of making payments. In other words, a zero credit banking system is the only safe system. Turner thinks this is too extreme a solution and instead proposes limits on banks' ability to create credit.

I would argue that an alternative is to have a public sector-dominated banking system. PSBs do not have the same incentives to create credit recklessly. That is because executive  pay is not linked to credit creation and the profit it generates. Secondly, unanticipated risks and losses and arise don't translate into bank failure and a banking crisis. Although depositors in India are insured only upto Rs 1 lakh of the deposits they hold, the public believes that the government stands behind their deposits in full. In other words, the sort of unlimited guarantee on bank deposits that came into vogue in Europe after the financial crisis of 2007 is something that is implicit in a PSB-dominated system.

This explains why we have not any failures in banking or a crisis despite the huge increase in NPAs in recent months. Even in the weaker PSBs, depositors are not queuing up to ask for their money. Contrast this with the situation in a large private sector bank in 2009 when the mere whiff of trouble almost caused a run on the bank.

Banks in India will have to fund projects whose risks are not always clear- as we have seen in infrastructure in recent years. Banks can't steer clear of these risks because there's nobody else to fund them- we don't have long-term financial institutions and bond markets to do the job. However, when these risks materialise, that should not translate into a banking crisis. These conditions can be met only with  a PSB-dominated banking system.

Free tuitions at top US universities?

America's top universities, such as Harvard, are under pressure from activists to make tuition free to their students, the Economist reports. The argument is a straightforward one: their endowments are so large that they don't to charge their students any fee- Harvard sits on an endowment of $36 bn.

American universities are not willing to offer free tuition or even reduce their fee, which has soared by 220% since 1980.  Why would they raise the fee when they can afford not to charge students? Simple. Higher fees mean greater power to spend- on new buildings, research, higher salaries for faculty. And if students can raise loans to pay the fee, why not? "We can rip off students, so we will"- seems to be the motto. Many will see shades of this in the IIMs' own propensity to raise fee in recent years.

American colleges argue that they try to care of needy students by providing financial aid- at Harvard, 70% of students are covered by aid of some sort. However, students still have to raise large loans to fund their education. The evidence is that this does come in the way of inclusiveness- those outside a small elite are intimidated by the thought of taking large loans to fund their education.

Again, one sees echoes of all this in the IIM system. The argument is made that most students can afford to take loans given that placement salaries are high. There are two flaws in this argument. One is that several students will still be discouraged from coming to IIMs  given the uncertainty about paying off large loans. The second is that high fees in the IIM system cause other B-schools to raise their fees even though their placement salaries are not high enough to justify the fee. So great is the demand for igher education that students will take the risk of going to lower B-schools even though they are not sure the salaries they will get will make the fee worthwhile.

Banking distress: containing the damage

FM Arun Jaitley has moved to contain the damage to morale in PSBs by emphasising recently that bad loans at PSBs are substantially the result of larger economic factors, they don't always point to bad decisions:

But there are also some other issues due to which non-performing assets have added up in the banking system," he said, adding that some genuine economic reasons for the delays in repayments to banks needed to be dealt with. In steel, he said, it was dumping by China. In sugar, it was low global prices, while in power, it was indiscriminate moves by some states to sell electricity below cost, forcing distribution companies to resort to borrowing. In highways, it was poor policy implementation that had crippled the sector, Jaitley said, listing the reasons for the rise in bank NPAs.

These observations are welcome. I am inclined to think, however, that much damage has already been done by strong statements made by people at the top and also by the media coverage of the issue. I would imagine that fear psychosis is pervasive and PSB bankers would be reluctant to lend to large corporates and especially for infrastructure. It does not help at all that the CBI has swung into action.Since the NPA position can't be tackled without fresh funds coming and projects moving towards completion, it does look as though the problem is going to stretch out for a while.

What can be done with stressed assets? Well, broadly there are three options:

i. Identify cases where the stress has happened for genuine reasons. In these cases, banks should take a hit and fresh money should come in. But PSBs will be most reluctant to do so in the present atmosphere. I would suggest that the government set up a Settlement Advisory Board comprising ex-bankers, chartered accountants, academics and others to vet loan settlements above a certain value. That would give bankers the courage to move ahead.  Fresh funds can come either from the banks or the National Infrastructure Investment Fund.

ii. Use SDR to convert debt into equity, dislodge existing promoters and management and bring in new promoters. This sounds fine in principle but it hasn't happened in a single instance so far. Borrowers can stymie such moves by approaching courts. Bankers don't have the expertise to find fresh promoters. Again, if new promoters are to come in, valuation issues will arise. I don't think SDR will work/

iii. Government takes over some of the stressed assets, completes the projects and repays banks' loans. So, for example, NHAI could take over road projects, SAIL could acquire steel projects, NTPC could acquire power projects and so on. The key issue is: do they have the ability to complete the projects in their present condition? In some cases at least, this is worth exploring.

While resolving stressed assets, we need to ensure that systems are strengthened so as to avoid a repetition of past mistakes. The Bank Board Bureau must professionalise bank boards and induct high quality people as MDs. The BBB is not as envisaged by the P J Nayak committee. The Nayak committee wanted a BBB without any government representatives. That is completely unrealistic in my view. Government as the owner has to take the lead in making appointments. The job of the BBB Chairman and other members is to ensure that the government gets these appointments right. But much depends on the intentions of the government.

The BBB is no merely the old Appointments Board minus the RBI Governor. The Appointments Board could not prevent wrong appointments. So the onus really is on government to make the right choices. One hopes that the present crisis brings out the best in government as crises typically do.

Hysteria over NPAs is not helpful

India's banking system, according to media reports, has stressed assets of about Rs 800,000 crore or about 11% of total assets. NPAs are a little over 4% and the rest are restructured assets. A quarter of restructured assets typically turn into NPAs. That means an NPA level of around 6%. That is way below the level of 15% in 1996-96. The NPA situation is challenging but not alarming, as the RBI governor himself has pointed out.

But that's not the impression you would get going by screaming newspaper headlines and raucous discussions on TV. You would also think that all of the NPAs reflect crony capitalism and are the work of crooked politicians and businessmen, aided and abetted by public sector banks (PSBs). Two solutions are being prescribed accordingly. Privatise PSBs- the government has ruled these out. Instead, the government would prefer consolidation of banks: as the FM puts it, we need strong banks, not many banks.

Let me deal with the diagnosis first. It's sheer nonsense to say that all or most of the NPAs are the result of poor judgement or mala fide decisions. Banking is a play on the economy. NPAs at PSBs reflect larger problems in the economy:

i. The global economic crisis is still unfolding and banks the world over are feeling the impact. European banks especially are in poor shape. A large number of banks are trading below their book value- as the papers mention, HDFC Bank is today worth more than global giant, Deutsche Bank.  The Indian economy, like other emerging markets, is facing the lagged impact of the global crisis. Banks are impacted as a result.

ii. More than half the stressed assets arising from five sectors- mining, iron steel, infrastructure, textiles and aviation. It was PSB finance that drove the infrastructure boom of 2004-08. So PSBs are more exposed to these sectors than private banks. They are more impacted as a result.

iii. Maybe PSBs should have been as clever as private banks and take a lower exposure to key sectors of the economy? Maybe they too should have focused on retail assets? Well, we don't have deep enough corporate bond markets. And we wound up development financial institutions years ago. So, if the PSBs don't fund key sectors, who's going to fund them?

iv. The infrastructure and related sectors have been impacted by several factors which could not have been anticipated: delays in land acquisition, problems with environmental clearance, adverse court judgements, a sudden slowdown in the Indian economy, etc. It's not that private banks judged these risks better because they too are exposed to the very groups and companies to which PSBs are exposed. It's just that they had lower exposures because their business focus is on other assets.

Let me now address the prescriptions.

•  Privatising PSBs is no insurance that the tax payer will not have to foot the bill arising from failed banks. Just look at the recurrent bouts of banking crises in over 100 economies worldwide. The media cost of recapitalising banks has been 6.8% of GDP. In India, the total recapitalisation cost over a two decade period of 0.5% of GDP. The cost of recapitalisation is not the real cost of banking failure. The real cost is lost economic growth. This cost can amount to 3% of GDP every year. India has not had a banking crisis. The cost of recapitalising PSBs is thus miniscule in relation to the larger cost arising from a banking crisis.
• Consolidation does not necessarily lead to a stronger bank. It's hard to make a success of mergers even in economies where the labour market has flexibility. Here, the HR issues would be very difficult to surmount. Since almost all PSBs are in a stressed state, it is not meaningful to add to the stress of an SBI or BoB by merging an even weaker bank with it. We must first rationalise and restructure all the weak banks. Then, we can take a view on which can continue on its own, which can be merged and which may be privatised.

 There is more to the banking sector than Kingfisher and Mr Mallya. The problems are fundamental and require addressing with a cool head. Hysteria will take us nowhere.

More in a couple of pieces I wrote recently:

http://thewire.in/2016/02/28/sense-and-nonsense-about-bank-losses-22972/

http://qz.com/626955/there-is-only-so-much-arun-jaitleys-budget-can-do-to-fix-the-rot-in-indias-banking-system/

Will the budget boost growth?

Well, it certainly doesn't attempt to do so through fiscal stimulus. We have a fiscal contraction. The point is missed by commentators who have been salivating over various items of expenditure, especially the huge jump in investment in roads. These increases are fine. But, leaving aside the fiscal deficit shrinkage, even public investment doesn't show a rise- M Govinda Rao points out in an article today that capital expenditure as a proportion of GDP actually declines from 1.8% in 2015-16 to 1.6% in the coming year.

The question is whether private investment can compensate through a drop in interest rates. Govinda Rao points out that looking at government borrowings alone is deceptive.We need to look at public sector borrowings. This would include central and state deficits and borrowings of the Railways and the special purpose vehicles for infrastructure. When we put these together and compare with total household saving of 7.6 per cent, there's very little room for lending to the private sector. The implication is that a cut in interest rates by the RBI is not going to help a great deal. I would add: banks' capital position is under stress, despite the move by RBI to let them count various items (such as revaluation of property and translation from foreign exposures) as capital.

The bottom line: since neither public nor private investment will rise and exports have been going downhill, we can't expect the growth rate in the coming year to be any different from that in 2015-16. And that's if the world economy doesn't go downhill. The decision to stick to the 3.5% target may well prove a mistake- unless, as I said earlier, the government will allow the deficit to slide up later in the year.

Definitely a Modi budget

The budget for 2016-17 bears the stamp of prime minister Modi. There is a philosophy and a political direction to it, which could have come only from the PM himself. 

There's a shift in focus- from industry to agriculture, from the urban middle classes to the rural poor. This is reflected in increased in allocations for a variety of rural schemes and the attempts to boost rural consumption. It also shows in a willingness to tax the rich (higher surcharge on incomes over a certain limit, taxation of dividend in the hands of the shareholder) and in the attempt to move PF contributions to EEE, that is, to tax withdrawals. (It appears this may be partially rolled back).
What has caused this shift? Several things, I guess:

•  The realisation that not much can be done to boost private investment and industry at a time when the global crisis seems to be worsening, large Indian companies face a debt overhang and the banking sector is bogged down by high NPAs.
• The recognition that if agriculture can be strengthened and made to grow faster, we can raise the overall growth rate without being dependent on the vagaries of the global economy. Also, that a turnaround in agriculture can translate into significant votes. That was Modi's achievement in Gujarat- to reach electricity and water to the rural areas. That was also Nitish Kumar's achievement in Bihar. 
• Once agriculture is improved, a revival in the world economy will help push India's growth rate into the 8-9% range, perhaps in time for the 2019 elections.

At the same time, there is a concern not to rock the boat where foreign investors are concerned, to shore up badly won macro-economic stability at a time when investors are pulling out of emerging markets. Hence, the focus on achieving the fiscal deficit target of 3.5%. Modi doesn't want foreign investors to mess up things for India by fleeing at this time.

The big negative in this strategy is inadequate recapitalisation of public sector banks- Rs 25,000 crore just isn't enough. I am inclined to believe the government when it says this isn't the entire figure they have in mind- more could be forthcoming. Perhaps, the government will get a clearer view of the capital requirement once consolidation of some sort is firmed up. They can then top up the sum of Rs 25,000 crore later in the year. If international conditions are a little calmer, they can afford to give the fiscal deficit target of 3.5% a miss and settle for, say, 3.7%.

As commentators have pointed out, there is a contradiction between sticking to the fiscal consolidation roadmap and then seeking a review of FRBM targets. Perhaps, the FM hopes that the promise review will give him leeway to relax the deficit by the time he presents the next budget.

What could go wrong? Well, what we have is a continuation of fiscal compression along with a little monetary loosening. This won't do much for growth. It's no use bringing down interest rates when banks lack the capital to be able to lend. This means growth is likely to be closer to the lower end of 7-7.5% band indicated in the Economic Survey.

One can live with that - provided the global economy doesn't get into worse shape. If it does, then growth could slip below 7%, foreign investors might yet flee and the banking sector's situation will become perilous.

Secondly, the allocations for agriculture, while higher than in previous years, may not be adequate to dramatically change the situation on the ground. Politically, then, Modi may not reap the expected dividend.

Clearly, there are risks to the budgetary strategy that the Modi government is pursuing. But this is clearly the strategy of a consummate politician- I can't see that any economic advisor could have crafted a budget of this sort.